Chinese land markets have yet to respond to crackdown on leverage

Top Chinese policymakers have highlighted the need to reduce leverage. However, the credit-fuelled momentum in mainland Chinese land markets, particularly in second-tier markets, has yet to respond.

In his opening address to the 19th National Congress of the Communist Party of China in October, Chinese President Xi Jinping highlighted the need to reduce credit growth on the mainland, stressing the shift from “a stage of high growth to a stage of high-quality growth.” Following the close of the meetings, People’s Bank of China (PBoC) Governor Zhou Xiaochuan reiterated this stance through a series of speeches and articles in the mainland Chinese press.

Home price growth slow, but land prices continue to trend higher

This position is not new for top officials in China’s government, which has been vocally hawkish on credit growth since the end of 2016. Although home prices have begun to respond to this, as shown in chart one, land markets (particularly outside of tier one-markets) continue to exhibit signs of froth.

Chart one: Chinese home prices, Y/Y %

Table one is indicative of this. Projecting land sales recorded in the January–August 2017 period through to the full year using data from 2010 to 2016, when the January–August period accounted for between 55–65% of overall sales in these years across the 34 markets tracked, land sales to developers will increase by around 15% on a year-on-year basis. Land sales in the larger tier-one markets of Beijing, Shanghai, Guangzhou and Shenzhen are set to post only modest growth, while those in smaller centres are on pace for much faster growth.

Table one: Projected 2017 land sales based on 2010–2016 figures

The table also attempts to illustrate what could happen if policy were to change suddenly before the end of the year. Under the low-growth scenario, it assumes that developers land purchases have already reached 70% of what they will purchase during all of 2017. This would be indicative of a much tighter credit environment where authorities have restricted lending.

However, even under this scenario, land sales in smaller markets would still be on pace to increase year-on-year. An alternative scenario, where only 50% of land sales for 2017 have been logged in the January–August period, is presented as the high-growth scenario.

Excess credit and a lack of assets inflating land prices

More capital being diverted to land amid a slowdown in home prices is indicative of a disconnect between valuations on land and home prices. Easy credit policies are likely partially responsible for this as, for the past 18 months, developers have had relatively easy access to credit, but lack investable assets to deploy this capital, they have instead built up their land banks.

Mainland Chinese developers also saw an increase in margins in 2016 as mortgage lending spiked; however, this trend looks poised to reverse. Chart two shows annual land purchases as a percent of total sales for developers in Beijing and Shanghai. It indicates that in January–August, land sales have eaten up a higher percentage of revenue than in prior years.

Chart two: Developers land purchases as a percent of sales, Beijing and Shanghai

Chart three shows the level of developers’ margins between sales value and land cost in Beijing and Shanghai. Given that land prices are the primary source of variation in a projects’ cost, this indicates that developers are likely to see a significant decline in profitability during the current fiscal year.

Developers in cities outside of Beijing and Shanghai are likely to experience a similar crunch, though the effects may come a few months later given how home prices outside of tier-one cities have lagged those in Beijing, Shanghai, Guangzhou and Shenzhen in the most recent cycle (see chart one). As I’ve written before, this will come as developers find traditional financing channels tightening in 2018 and face heightened refinancing requirements.

There are some signs that developers are beginning to take heed of the Chinese government’s warnings on leverage. Throughout 2017, land in first- and second-tier markets has been consistently sold at the top of the government’s allowed band, it was not unusual for land to transact at a 100% premium to pre-auction valuations, and in some cases exceeded 200%. However, that has since changed. On 3 November 2017, it was reported that a land plot for sale on the outskirts of Beijing failed to sell at auction — the first failed sale of a residential land plot in Beijing since September 2015. Two other land plots within the city were sold at a 0% and 0.5% premium of the pre-auction valuation, a dynamic that is likely to trickle down into smaller markets.

With less cash buffers heading into 2018, this will be a particularly tricky year for smaller developers outside of tier-one markets. While developers in tier-one cities benefit from access to the big five state-owned banks , outside of these cities developers often rely on regional or local joint-stock banks that do not benefit from implicit government support. As shown in chart four, these small to mid-size banks are much more reliant on shadow-banking activities and off-balance sheet funding.

Chart four: Mainland Chinese bank funding, loan exposure

Additionally, unless new legislation is passed, developers will be required to proceed with projects as there are limitations to the period they can hold land without developing it. It is unlikely that this this will be changed as it would result in a sharp slowdown in construction, a major pillar of the economy, which would send ripple effects into other sectors.

Slower growth is healthier growth in the short run

China’s officials have a choice of several paths for policy, but not without consequence. The fall-back option has traditionally been to continue to increase lending. This could be done by extending more credit to developers, which could either use these new funds to pay off old debts (evergreening of loans) or invest. However, the former is essentially monetary destruction as throwing new money at old debts is not an economically productive activity. The latter would likely just further inflate a bubble in land markets as a lack of investable assets within China and increased scrutiny on developers moving cash abroad has left domestic land markets as the only investable asset class left for mainland Chinese developers.

The government could also adopt a more nuanced strategy and reverse home-price restrictions, allowing for banks to increase mortgage lending. This would essentially funnel cash to developers in the form of revenues rather than debt, allowing developers to pay-down debts while maintaining a level of productive activity (the construction of new projects on previously purchased land). However, this doesn’t solve the issue of developers’ debt burden, but rather shifts it to households, whose balance sheets are already showing signs of deterioration.

Ultimately, continuing to increase leverage will only exacerbate the problem rather than solve it. Any approach that depends on credit continuing to be increased is likely to either end in an acute credit crunch (the “hard-landing” scenario) or a sustained drain on productivity, resulting in structurally lower growth in the long run (akin to Japan’s “lost decade” of growth). Outside of China there are growing concerns over the continuation of mainland Chinese credit growth; the European Central Bank is the latest to issue a warning on the global implications of China’s rebalancing.

Credit conditions will need to tighten and bad debts will need to be recognised. It is likely that a portion of the banking system would need some recapitalisation, and there would be a slowdown in growth over the short term. However, this would be a cyclically slower period of growth rather than a structural slowdown in growth — an important distinction as the former would allow for substantially higher potential growth rates in the long run.

How China’s leaders address this issue over the next 24 months will be influential in shaping the next several years of economic growth, both in China and globally. President Xi’s focus on healthy growth rather than a specific target indicates some willingness to tackle excessive leverage. Although there are short-term risks to this approach, it is likely to pay dividends in the long run, both inside and outside of China’s borders. As shown in chart five, China has been a stable source of growth for the global economy since the onset of the Global Financial Crisis. Rebalancing China’s economy away from a reliance on debt and investment will ensure that this persists in the decades to come.

Chart five: China’s contribution to global growth

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